- Created by: erised
- Created on: 12-06-17 10:06
- Derived from the IS-LM equilibrium.
- We assume an increase in prices. The supply of real money balances decreases shifting the LM curve to the left leading to a lower level of output.
- Therefore a higher level of prices leads to a lower level of output
- The AD curve sums up this negative relationship between prices and output.
AS- Wage Setting
The nominal wage, w, depends on three factors:
- Expected price level,
- Unemployment rate, u
- A variable, z
AS- Price Setting
Firms set their price according to :
is the mark-up of the price over the cost of production.
- Combine the price setting and wage setting by putting them both equal to w
- Express unemployment rate in terms of output:
- Therefore for a given labour force, the higher the output, the lower the unemployment.
- Replace the uneployment rate with the equation in step 1.
Properties of AS
- An increase in output leads to an increase in the price level. (Increase in Y leades = increase in N = decrease in u = increase in w = increase in p) - upward sloping.
- An increase in the expected price leads to an increase in the actual price (increase in Pe = increase in w = increase in P)
- The AS curve goes through point A where Y=Yn (natural rate of output) and P=Pe. This means when Y>Yn, P>Pe and when Y<Yn, P<Pe.
- An increase in Pe shifts the As curve up and a decrease in Pe shifts the AS curve down.
Equilibrium in the Short Run
At point A the labour market and the goods market are all in equilibrium
Equilibrium in the Short-Medium Run
- Wage setters will revise upwards their expectations of the future price level.
- This causes AS to shift upwards
- This leads to a higher nominal wage and a higher price level.
- The adjustment ends once wage setters no longer have reasons to change their expectations.
- In the medium run, output returns to natural rate.
Effect of Monetary Expansion
- In the AD equeation - an increase in M leads to an increase in the real money stock (M/P)
- This leads to an increase in output and the AD curve shifts to the right.
- In the short run the output and price rise.
- The difference between Y* and Yn sets in motion the adjustment of price expectations
- In the medium run, the AS curve shifts left and returns the economy back to Yn.
- The increase in prices is proportional to the increase in the nominal money stock.
A monetary expansion leads to an increase in output on the short run but no effect in the medium run.
Effects of Fiscal Contraction
- A decrease in public spending = decrease in output.
- Decrease in output = real money stock rises = LM curve shifts to the right.
- IS curve shifts left to restore equlibirum = both Y and r and lower than before
Deficit reduction in the short tun leads to a decrease in output and interest rates. In the medium run output returns to its natural level while the interest rate keeps falling further.